The dangers of the shorted short sell

I know something is a story when my wife gloms onto it. So, it was pretty extraordinary when she focused on the financial crisis involving short sellers of GameStop stock. I’m doubtful she even understands what shorting a stock means. I’ve watched a half dozen videos on this and I still find it confusing. What she does understand is that some “little guys” found a way to hurt big investors and make them pay. That got her attention and made her absolutely gleeful.

When you short a stock, you are basically betting on a stock’s price going down. Counterintuitively, when the stock goes down, you make money. This happens not because you own the stock, but because someone lent them to you for a fee and sold them to you at the then going market price. You really only are lent the stock though because you must pay them back at an agreed upon date, which you do by selling them again before or when you have to sell them. If they go down in price while you were lent them, you pay less to buy them on the open market, keeping the profit.

If this sounds risky, it is, which is why it’s a game generally played by large institutional investors that can take the time to research stocks and make hopefully informed bets on which stocks are likely to tank. That’s because you don’t know for sure the price will go down, so you need the credit to pay back the market value of the stocks you were loaned if they go up and you don’t have the cash to sell them at their current market price. If they go up a lot, you could go bankrupt.

Stock shorting is completely legal, but that doesn’t mean it should be. As we learned this week, the system can be gamed, in this case by Reddit forum readers. They discovered that there were more shares of the stock being sold short than existed, a phenomenon made possible because there is nothing stopping a short seller from selling his temporarily owned stocks to another short seller. If a lot of little investors buy up a lot of this stock, not only will its price go up artificially, but short sellers take it on the nose when they have to pay more to buy the stock than they paid for it.

In the case of GameStop, there was for a time literally no shares to buy. That’s because stock trading apps like Robinhood, but really the brokers they use to trade these stocks, could not buy more of a stock when there were no shares for sale. In Robinhood’s case, it did not allow you to buy GameStop, but it would allow you to sell shares you had. This has the effect of lowering the price of the stock, which mitigated the loss of large institutional investors into short selling. In short, at least for a time, the game was rigged in favor of large institutional investors.

But at least for a little while, the little guys won. They effectively transferred a lot of wealth from these large companies into their pockets instead. They did it by artificially inflating a stock’s value well beyond its worth by earlier buying the stock, and counting on the fact that the stock was so over short-sold they would cost an obscene amount to buy when short sellers were required to buy back the stock at the going rate.

Robin Hood indeed. In this case though the money did not flow from the rich to the poor, but from the rich to probably mid-tier investors who learned they could out-short the short sell system through collective action. They are doing the same thing with other stocks currently often short sold, like the AMC movie theater chain. Any company in what appears to be a disappearing market becomes a likely short sell candidate stock. All these stocks are almost certainly bad long term investments, but at least for a while they can look obscenely profitable.

What if anything should be done about this? If it were up to me, I’d make short selling illegal. You should not be able to buy any stock on money you don’t have. Of course, Wall Street runs on borrowed money, so they wouldn’t like my approach to solving this problem. To them, it would be like someone not being able to replace their roof until they had the cash. This argument doesn’t work with me. Replacing your roof is a necessity. Buying a shorted or even undervalued stock is not a need; rather it’s a want.

So, it’s a game I won’t play, but it’s one I and all of you may end up playing indirectly. We’ve got plenty of money in stocks, just indirectly through mutual funds and EFTs. And they are all managed through middlemen. Right now, much of our wealth is in TD Ameritrade, but it’s likely to move to BlackRock, the world’s largest investment fiduciary. BlackRock also manages lots of funds that specialize in short selling. I don’t want any of my assets to be tainted by any of these funds that BlackRock may manage, but maybe it would. Maybe it would drag down investments as a whole if too many of these assets are in shorted stocks.

This may itself explain the stock market’s recent slump. It’s trying to price in what’s going on with the new uncertainty in the short selling market. The only real way to remove this uncertainty is to regulate it, so hopefully the SEC will institute some rules. From my perspective, short selling would become illegal just as selling and buying stocks based on insider information is today.

I don’t see much difference between what we are seeing now with shorting the short sellers and the house of cards that collapsed in the Great Recession. The difference this time though is regulators have the ability to handle this before it becomes a much greater risk to the financial system. I’m hoping they will sober up in time before all us investors are disproportionately affected.